Insurance 101: Using Swaps and Options to Lower Your Trading Risk

While swaps and options have many uses, one of the most important is to reduce trading risk. Using these tools to hedge your trade against loss is analogous to taking out an insurance policy on your position; you pay a little more to get a lot of peace of mind.

Swaps

Swaps are typically not standardized contracts that trade on exchanges. Instead, corporations and large investors create customized swap contracts to lower borrowing costs, hedge against fluctuations in interest rates or currencies, and to protect against the risk of default. This last type is the Credit Default Swap (CDS) which guarantees that if a debtor defaults on its debts, the seller of the swap contract will pay the buyer of the contract some amount, typically the principal amount of the defaulted debt. These type of arrangements are becoming available to retail investors in the form of Credit Event Binary Options (CEBOs). These options, traded on the CBOE, pay a fixed amount in the event of the uderlying company's bankruptcy. If you're an equity or fixed income investor concerned about default risk, Credit Event Binary Options are a new addition to your hedging toolbox.

Options

A common way to hedge in the equities market is to buy a put option against an existing long position in a stock or to buy a call option to protect a short position. As the option expires, you must replace it with a new one, making this very much like paying insurance premiums on your stock position. In the FOREX market, the most common risk control measure is to place a stop order, but this is not always the best solution. Slippage in a fast market or even an entry error on your part may expose you to more risk than you expected.
An alternative solution is to use binary options, either in place of, or in addition to your straight currency position. A typical binary option will either pay out a fixed amount or nothing at all depending on where the underlying currency price ends up at expiration. Under this arrangement, you always know your potential risk and reward, and these are never unlimited. Binary options brokers can help you hedge trading risk with limited loss options.

Summary

While stop orders are an important risk control measure, they may not always be the best or only choice. Alternative risk control measures include standard options, binary options, and possibly even Credit Event Binary Options which bring the strategy behind Credit Default Swaps to the retail investor.
What do you think about this strategy? Join the discussion here.Rianne Hunter is a wife, mother of three, and finance author. She enjoys researching and covering all things finance, investment, and business.

At SprinkleBit, founded in 2011, we believe that if you have a dollar, then you have what it takes to be an investor. Sometimes you just need a little extra help to build your confidence. With our virtual simulator and our 24 free SprinkleBit University chapters, you will be able to learn the ins and outs of the market risk-free. Once you're ready to dive into the real thing, the community will be right there with you to help you on your journey. Dive in and start taking control of your financial future. You won't regret it.